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FRM Part I · FRM Exam Part I · The Black-Scholes-Merton Model

A listed company issues warrants to outside investors, each exercisable into one newly issued share. Compared with an otherwise identical exchange-traded call option on the same stock, why is the warrant's value generally lower?

The warrant is worth less because exercising it makes the company issue new shares. The extra shares dilute the value per share, so the holder's payoff is smaller than on an equivalent exchange-traded call, which is settled between investors without changing the share count.

  1. AWarrants always have a shorter maturity than exchange-traded options
  2. BWarrants cannot be valued with the Black-Scholes-Merton model because they are traded over the counter
  3. CExercise causes the company to issue new shares, so the payoff is diluted across a larger share countCorrect
  4. DWarrant holders receive dividends, which reduces the value of the right to buy the stock

Explanation

When a warrant is exercised the firm issues new shares and receives the strike price, which dilutes the value per share. An exchange-traded call is settled between investors with no change in share count. This dilution makes the warrant worth less than the equivalent call. Maturity and venue are not the cause.

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